Annuities 101

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By Jason Alderman
Columnist

POSTED:July 6, 2011 12:20 p.m.

Nervous investors have faced many challenges over the last few years searching for safe havens. That’s one reason many turn to annuities to ensure a steady stream of retirement income. But with so many types of annuities offered – and complex rules, fees and restrictions – it’s not uncommon for investors to buy products not ideally suited to their needs. Here’s a brief primer on how annuities work:Annuities are insurance products that pay out income. Typically, you make a lump-sum or series of payments to the seller. In return, they agree to pay you periodically for a definite period (say 20 years) or an indefinite period (until death) in one of two ways.Immediate annuities begin paying benefits the year you deposit your money. With deferred annuities, your account grows on a tax-deferred basis until you begin receiving payments at a later date.There are three basic types of annuities: • Fixed annuity. You’re paid an agreed-to rate of interest while your account is growing and receive periodic payments of a specified amount. • Indexed annuity. The seller provides an investment return based on changes in a particular index (such as the S&P 500). • Variable annuity. You invest your account among a variety of options (typically mutual funds) and your rate of return and payment amounts will depend on their performance. Many people purchase annuities because they grow tax deferred – that is, your contributions are not taxed, but any earnings they generate are taxed at your regular income tax rate. Annuities have no annual contribution limit, but you’ll pay a 10 percent federal tax penalty withdrawals before age 59 ½. One big tax disadvantage is that, whereas earnings from money invested in stocks, bonds or mutual funds is taxed as capital gains, annuities are taxed at regular income tax rates, which can be significantly higher. Annuities can be very expensive compared to other types of investments. Before signing any agreement investigate: Sales commissions, which initially can run as high as 10 percent, plus ongoing commissions in subsequent years. Depending on what type you buy, you could be charged an additional 2 percent or more per year in various account management fees. Most deferred annuities charge an early withdrawal penalty called a surrender charge, which usually starts at 7 or 8 percent and gradually declines to zero. However, they can also be much higher, so read your contract carefully.Also, consider consulting a fee-only financial advisor versus one who earns commissions recommended products. Because 401(k) plans and IRAs are already tax-deferred and have lower fees, it may not make sense to roll over those balances into an annuity.